Why unregulated cryptocurrencies could trigger financial crisis

The price of bitcoin hit $17,000 late last year and – although the cryptocurrency has plunged since then – there are signs that an absence of regulation can hurt investors and trigger the next financial crisis.

Despite the laudable blockchain technology and the great opportunities it offers in enabling quicker transactions, numerous problems can be associated with its products – such as bitcoin and other cryptocurrencies – if regulation is delayed. As I have previously argued, global measures for the use of digital currency should swiftly come into force.

However, it’s worth considering how the market for cryptocurrencies has grown outside of any concrete regulatory framework leading to a number of potential risks.

Money

For a cryptocurrency to function as money it needs to fulfil three requirements.

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First, it should act as a medium of exchange whereby people can use it to buy and sell. This is the most promising feature of the blockchain technology as it facilitates peer to peer transactions across various industries.

Second, it must be a store of value. However, due to the bitcoin’s price volatility, it doesn’t meet this requirement. According to a report from Goldman Sachs, bitcoin was six times more volatile than gold in 2017.

Third, it should be a unit of account – in other words, used to represent the real value or cost of an item. Again, due to its volatility, only a few businesses are currently prepared to accept bitcoin before they know details of the fiat currency equivalent.

Importantly, cryptocurrencies would not need to be classed as money for them to be able to trigger a financial crisis. They simply need to be treated or traded as financial securities and/or commodities, and for enough systemically important financial institutions to hold and trade them when a downturn occurs – as was the case in the 2008 financial crisis.

Financial security

Bitcoin and other cryptocurrencies operate in many ways like a financial security such as a stock or commodity. Here, they have been used mostly by blockchain startups as a means to fund projects or business ideas by issuing digital “tokens” to subscribers who pay using mechanisms including prominent cryptocurrencies – such as bitcoin or ether – or through fiat currency in order to acquire proprietary interests in the business or project.

Some firms have used this as a mechanism to raise finance to start businesses. These startups would have found it almost impossible to raise finance through the traditional initial public offering (IPO) method, due to regulatory requirements that they probably wouldn’t have been able to fulfil.

Under an IPO, companies need to be listed on a domestic stock exchange and, to do so, are required to fulfil prospectus requirements including disclosure of their accounts. This method is designed to protect retail investors and preserve market integrity.

By bypassing any requirement to access financing from the public through exchanges or intermediaries, it becomes cheaper, quicker and easier for new companies to raise funds to finance their business. Blockchain startups have raised over US$1.5 billion in funding through ICOs (initial coin offerings) since the start of 2017.

However, ICOs do not receive the same regulatory scrutiny as IPOs. Instead, a firm seeking financing via an ICO is expected to circulate a white paper setting out the basic objectives of the business, the cost of setting it up and how this would be done. And that’s it.

But because the business is a blockchain company and the issuing is done on that digital ledger of transactions, the identity of those subscribing to tokens are hidden. The true identity of the issuing company may also be disguised regardless of statements in the white paper – which poses a potential threat to subscribers.

As the true identities of parties are largely unknown and as regulation within this space is sparse, firms seeking funding in this way currently aren’t obliged to know their subscribers under, for example, anti-money laundering (AML) requirements. Which makes these platforms easy targets for miscreants.

Commodity

Bitcoin has no intrinsic value and the surge in its price in December 2017 was largely driven by speculation. This is also associated with the argument that it is a bubble – which is when an asset trades at a price that strongly exceeds the intrinsic value. Very little needs to happen before that bubble might burst, such as the introduction of more regulation or another hack of a major cryptocurrency exchange.

But if the bubble bursts, could it trigger a financial crisis on the same scale as that of 2008? It would depend on whether or not cryptocurrencies and their derivatives can pose a systemic risk to the financial system. And it is a possibility.

In 2007, the fall in the value of mortgage-backed securities in the US and their ensuing derivatives held by financial institutions resulted in a credit crunch among banks which precipitated the financial crisis a year later.

Back to the future

Selling Apples outside the New York Stock Exchange on September 30, 2008, the day after the record-breaking 777-point drop in the Dow.Shutterstock

This scenario can be dismissed on the basis that – at the moment – cryptocurrencies do not pose such a risk because they aren’t mainstream. But it is clear that an increasing number of systemically important financial institutions engage in trading cryptocurrencies such as bitcoin. Once cryptocurrencies become more mainstream the tables could turn very quickly and exposure to digital currency could pose a systemic risk.

It’s worth remembering that part of the rationale for the inception of digital currency included dissatisfaction with banks and other financial institutions. And it’s no surprise that bitcoin was developed within a year of the credit crunch. While the introduction of cryptocurrencies has arguably been a “panacea” for the prevention of a financial crisis on the scale of 2008, it may yet lead to the next financial crisis if regulation is delayed.